Barron’s ran an article this weekend on the distortions ETF flows may be creating in individual stocks. This is an issue we have written about at length in our monthly strategy reports. ETF investors along with High Frequency Traders, and corporations (think buybacks) now account for a majority of stock market volume. These investors aren’t focused on underlying company fundamentals and values. HFTs are focused on scalping the next penny increment or two from buyers and sellers, corporations are focused on propping up quarterly EPS via buybacks (IBM is the poster child here), and ETF investors are primarily index-based asset allocators who pay little attention to stock market values and even less to individual company fundamentals.
But according to Barron’s, via a report from Goldman Sachs, ETF trading has grown to account for about one-quarter of overall share volume. The problem is most pervasive in small sectors of the market such as Real Estate Investment Trusts (REITs). Over the last three months, Goldman estimates that about 20% of Boston Properties trading volume could have been driven by ETF demand rather than by investors taking a specific view on the company’s fundamentals.
What are the investment implications of the growing influence of ETF investors? One logical conclusion is that prices can be expected to far overshoot fundamentals on both the upside and the downside. Today, it is safe to say we are well into the overshoot phase.